Growing up, I did not care much about Guns n’ Roses and yet it was impossible to avoid this t-shirt:
Kill Your Idols is a saying of advice to artists of all sorts to eliminate the behaviors or styles of their “idols” or what they took influence/inspiration from (Urban Dictionary). It is a cathartic act, a purification that brings the artist to a positive change, a renewal. The artist cannot move forward if they do not kill their idols first.
Believe it or not, finance has its own creators and “artists”. Lew Ranieri created mortgage-backed securities. Michael Milken created junk high-yield bonds. Ok, let’s keep it simple: John Bogle created Index Funds. Happy now? Yes, Satoshi Nakamoto created Bitcoin.
It is not clear who created the 60/40 portfolio, apparently might have been Bogle almost a century ago. What is clear is that investors, especially “medium-risk” ones, loved it. For many years, the essential macroeconomic factor that bond prices rise when stock prices drop and vice versa allowed the 60/40 portfolio to improve the risk-adjusted returns of a portfolio. Simple and effective.
If you read anything finance-related in the last three months, you probably stumbled on an article proclaiming the death of the 60/40, most likely related to this:
I get it. If you are paid by click, titles like this generate plenty of traffic for sure.
But is there something more? Is the 60/40 death the only way to move forward? Do investors need to kill their idol and move forward? Probably not.
The 60/40 have been declared death multiple times in the past and yet it came back every time:
The issue with the 60/40 Portfolio
The reason why this strategy became so popular is that it provided solid returns with relatively low volatility and drawdowns:
In simple terms, this happened because in a “normal” recession Central Banks cut interest rates to sustain the economy; lower interest rates means higher bond prices: when stocks suffer, bonds provide positive returns to the portfolio. When the economy is strong, Central Banks increase rates causing bond prices to go down, but this loss is more than compensated by stock gains.
See the red bars in the above picture? That’s where the main problem for this strategy hides: high inflation. Again, I am simplifying the matter a bit: to fight high inflation, Central Banks have to increase rates up to the point where they (most likely) cause a recession. In this scenario, rates might go up not when the economy is strong but when it is already weak. In this environment, stocks and bonds lose value at the same time.
There has been a perception issue.
After “defeating” inflation in the ’70s, bonds had a multi-decade bull run because, after each recession, rates in the US reached a lower high compared to the previous cycle.
This was largely possible because inflation, as measured by the CPI index, remained contained:
With the inflation monster under control, the FED could concentrate on “managing economic growth”, using rates to stimulate (often) or cool down (way less often) animal spirits.
The 60/40 worked so well for so long because inflation was out of the radar. And now Hobbitville has been suddenly woken up to face the menace of Sauron again. In reality, the strategy has always had its ups and downs:
An Ulcer Index of 10 is roughly half of the same risk measure for the S&P500…but it is not zero, what I feel you would expect reading all the 60/40 mortuary announcements. Look in terms of drawdowns, it is bad but there has been worse:
There is a model issue.
“Markowitz formalized the role of diversification when he showed how to construct optimal portfolios given the expected returns, standard deviations, and correlations of their component assets. Nearly 70 years after it was introduced, the mean–variance paradigm has proven surprisingly robust. However, it makes two implicit assumptions about diversification that warrant careful consideration. Because it relies on a single parameter to approximate the way each pair of assets co-vary, mean–variance optimization
assumes that correlations are symmetric on the upside and downside. Moreover, the approach assumes that diversification is desirable on the upside as well as the downside. The first assumption is occasionally correct, but the second assumption never is.“
This is an excerpt from this paper, where the authors try to formalize a portfolio construction framework similar to what PortfolioCharts does with the 15-year Baseline Return and the Ulcer Index, or in their words “place greater weight on downside correlations when setting policy weights, thereby constructing a static portfolio that is more resilient to downturns.” The paper concludes that seemingly more diversified portfolios than the standard 60/40 (which is not even that standard to begin with, considering that not everyone even agrees what should go in the 60 and what in the 40) achieve less risk-adjusted returns because the diversification works only when it should not, i.e. when stocks go up. In short, the investor should be really careful to add assets that provide diversification when it matters.
The paper is quite ‘lite’ in terms of tested assets; the geographical distinction among stocks (US, Europe, Asia) is useless if not misleading at this point, would be better to test by factor (value, growth, momentum and so on). “Commodities” as an asset class is also a too broad category: gold behaves in a very different manner than oil, so the analysis should include some distinction between raw materials.
The team at AlphaArchitect published a great post on the role of bonds as diversifiers in…2016 that proved to be prescient. To tackle the issue of measuring diversification that matters, AA uses the approach of Crisis Alpha (the excess return of an asset given that the stock market has declined by more than 5% in a month). While a 5% decline in a month might feel very exceptional, it is not and in c10% of the months between 1926 and 2016 stocks were in a drawdown of at least that magnitude.
The research piece shows that in Crisis Alpha months, bonds provided a 0.12% excess return and had a positive excess return 56% of the time, concluding that:
the diversification benefit of bonds may be smaller than people realize – bonds have produced a positive excess return only 56% of the time in Crisis Alpha months (no more frequent than in “normal” times) and they have only provided an excess return of 0.12% in Crisis Alpha months (compared with 0.22% for “normal” months).
There is a benefit but it is small (still, higher than cash) and it almost happens with the same frequency as a coin-flip…therefore all the articles about the “death of 60/40”.
The analysis gets even more interesting when AA decomposes bond returns into income and price:
The majority of bond’s excess returns come from the income component while prices have actually been negative.
So what is going to happen when bonds have very low yields and bond indexes have higher duration, AA asked in 2016? “we may want to lower our expectations of bond performance during Crisis Alpha months”. Sounds familiar?
Is there a better solution?
AA conclude their piece with this statement: it might be time to start looking for other investments or investment strategies to generate positive excess return during Crisis Alpha months.
While ex-post, we all know what happened in the last six months and counting, the above sentence might prompt an emphatic “NO SHIT”, finding the issue was way way easier than presenting a solution. In fact, not a lot has worked this year:
Going back to my beloved PortfolioCharts, there are plenty of strategies that provide better Ulcer Index-adjusted performance and this is not yesterday’s news:
That said, none survived this year’s slaughter:
The beauty of the 60/40 is that it works AND it is simple. Not only do all the above strategies require more asset classes to manage, there are exponentially more historical correlations that can break in the future.
Another possible solution is market timing strategies, like the Verdad model I wrote about a month ago. Dynamic strategies require reliable indicators to indicate and (ideally) forecast where we are in the business cycle…other elements that might have worked in the past but might not in the future. They also demand great discipline: the investor has to sell when things look great and buy when everyone else is puking. If you decide to start the journey, be sure that your hand will be firm, otherwise your P&L will suffer even if you have the best strategy in the world.
The ultimate silver lining for the 60/40 is that bond yields have already gone up. Part of the issues that brought the strategy where it is today is already gone. If you are Dollar Cost Averaging into the strategy, you are buying today’s higher yields (and lower valuations on the stock side) that will cushion future losses.
Bond investors will likely start to demand again protection against future inflation in terms of (even) higher yields, a premium that long-term bonds stopped paying in the recent past. If future inflation ebbs and flows instead of peaking and then stays low, the 60/40 strategy will better handle inflationary periods for this reason alone. The current volatile period will make the strategy better in navigating future volatile periods, even if they will not materialize.
Grateful dead
Is 60/40 really dead? Like the value factor, we would probably die first before knowing 😉
For sure, the 60/40 is an ungrateful strategy (at face value). When markets are up, it will be up less and definitely will never make any news (or a great topic at a party); when markets are down, it will be down less but…who cares? the investor lost money, that’s what drives the conversation. No one eats risk-adjusted returns, they say…
Still, unlike the journalist/blogger chasing clicks, the patient investor would enjoy the 60/40 ride…and the levered investor even more.
What I am reading now:
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